Exchange Rate Determination and Optimal Economic Policy by Eelke de Jong

By Eelke de Jong

1.1 a few features of the floating trade price process The versatile alternate fee process has functioned some distance much less satisfactorily than many expected in 1973, while the main industrialized international locations determined to enable their currencies glide. The dominant currencies' alternate charges have fluctuated extra 1 than anticipated. those fluctuations challenge either momentary move- intraday fluctuations and routine in the course of every week or a month - and lengthy­ time period adjustments that final for greater than a yr. day-by-day percent alterations of 1 percentage will not be strange for the new flow (see MacDonald, 1988, p.8). even if, the discharge of latest details can provide upward push to a lot greater adjustments. for instance in August 1987 "the buck moved down 6 percentage in days in accordance with the July alternate figures" (Glynn, 1988, p. 36). For the interval 1973-1985 MacDonald (1988, p.10) provides minimal and greatest per month percent alternate expense adjustments. those figures basically illustrate the importance of the volatility and in addition exhibit that the volatility has now not lowered because the adventure 2 with floating has elevated. as well as this volatility, alternate charges also are characterised via misalignment: "persistent departure of the alternate fee from its long-run equilibrium" (Williamson, 1983, p.l3). even if the degree of misalignment relies on the precise definition of the trade rate's long-run equilibrium, there's a frequent feeling that in the larger a part of the Nineteen Seventies the buck was once undervalued, while it was once puffed up throughout the first 1/2 the 1980s.

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43. 7 Omitted aspects of exchange rate determination In addition to inappropriate assumptions in the theoretical model or inadequate proxies of relevant variables, the asset market approaches' bad performance might also be due to the neglect of some possibly important aspects of exchange rate determination. The first factor to be considered is the omission of the stock of domestic interest bearing assets in the exchange rate equation. 34), this stock enters the exchange rate equation of the portfolio balance approach.

9): 8 the weight of zt- i is equal to tl,-(1-8 1) i. This once again illustrates that the hypotheses considered so far See Cagan (1956), pp. 36-41. He derives the formula for a continuous time model. A derivation of the equivalent formula for the discrete time model is presented in Begg (I 982), pp. 23,24. 8 47 EXPECTATION FORMATION make use of only the variable's own history. The regressive expectations hypothesis does not restrict the set of information to the past observations of the variable in question, and so belongs to the second group mentioned in the beginning of this section.

Using the autoregressive and integrated parts of the ARIMA model we can derive expectations hypotheses which assume that the expected value is a weighted sum of past observation only. For example, the ARIMA(O,l ,0) model yields the static expectations postulate, whereas the ARIMA (I, 1,0) model generates the extrapolative or bandwagon (Frankel and Froot, 1985) expectations hypothesis. 7) 7 Fase and Van Nieuwkerk (1975) inspired us to use ARIMA models as the general framework for the non-rational expectations hypotheses.

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